Lecture 18 Markets for Input Factors Economics for Business

Reference Nellis & Parker Ch Mankiw ch18 Lecture notes

18 The Markets for the Factors of Production

Factors of production are the inputs used to produce goods and services.

The Market for the Factors of Production The demand for a factor of production is a derived demand. A firm ’ s demand for a factor of production is derived from its decision to supply a good in another market.

THE DEMAND FOR LABOR Labor markets, like other markets in the economy, are governed by the forces of supply and demand.

Figure 1 The Versatility of Supply and Demand Copyright©2003 Southwestern/Thomson Learning Quantity of Apples 0 Price of Apples Demand Supply Demand Supply Quantity of Apple Pickers 0 Wage of Apple Pickers (a) The Market for Apples(b) The Market for Apple Pickers P QL W

THE DEMAND FOR LABOR Most labor services, rather than being final goods ready to be enjoyed by consumers, are inputs into the production of other goods.

The Production Function and the Marginal Product of Labor The production function illustrates the relationship between the quantity of inputs used and the quantity of output of a good.

Table 1 How the Competitive Firm Decides How Much Labor to Hire Copyright©2004 South-Western

Figure 2 The Production Function Copyright©2003 Southwestern/Thomson Learning Production function Quantity of Apple Pickers 0 Quantity of Apples

The Production Function and the Marginal Product of Labor The marginal product of labor is the increase in the amount of output from an additional unit of labor. MPL =  Q/  L MPL = (Q 2 – Q 1 )/(L 2 – L 1 )

The Production Function and the Marginal Product of Labor Diminishing Marginal Product of Labor As the number of workers increases, the marginal product of labor declines. As more and more workers are hired, each additional worker contributes less to production than the prior one. The production function becomes flatter as the number of workers rises. This property is called diminishing marginal product.

The Production Function and the Marginal Product of Labor Diminishing marginal product refers to the property whereby the marginal product of an input declines as the quantity of the input increases.

Figure 2 The Production Function Copyright©2003 Southwestern/Thomson Learning Production function Quantity of Apple Pickers 0 Quantity of Apples

The Value of the Marginal Product and the Demand for Labor The value of the marginal product is the marginal product of the input multiplied by the market price of the output. VMPL = MPL  P

The Value of the Marginal Product and the Demand for Labor The value of the marginal product (also known as marginal revenue product) is measured in dollars. It diminishes as the number of workers rises because the market price of the good is constant.

The Value of the Marginal Product and the Demand for Labor To maximize profit, the competitive, profit- maximizing firm hires workers up to the point where the value of the marginal product of labor equals the wage. VMPL = Wage

The Value of the Marginal Product and the Demand for Labor The value-of-marginal-product curve is the labor demand curve for a competitive, profit- maximizing firm.

Figure 3 The Value of the Marginal Product of Labor Copyright©2003 Southwestern/Thomson Learning 0 Quantity of Apple Pickers 0 Value of the Marginal Product Value of marginal product (demand curve for labor) Market wage Profit-maximizing quantity

FYI—Input Demand and Output Supply When a competitive firm hires labor up to the point at which the value of the marginal product equals the wage, it also produces up to the point at which the price equals the marginal cost.

What Causes the Labor Demand Curve to Shift? Output Price Technological Change Supply of Other factors

THE SUPPLY OF LABOR The labor supply curve reflects how workers ’ decisions about the labor-leisure tradeoff respond to changes in opportunity cost. An upward-sloping labor supply curve means that an increase in the wages induces workers to increase the quantity of labor they supply.

Figure 4 Equilibrium in a Labor Market Copyright©2003 Southwestern/Thomson Learning Wage (price of labor) 0 Quantity of Labor Supply

What Causes the Labor Supply Curve to Shift? Changes in Tastes Changes in Alternative Opportunities Immigration

EQUILIBRIUM IN THE LABOR MARKET The wage adjusts to balance the supply and demand for labor. The wage equals the value of the marginal product of labor.

Figure 4 Equilibrium in a Labor Market Copyright©2003 Southwestern/Thomson Learning Wage (price of labor) 0 Quantity of Labor Supply Demand Equilibrium wage,W Equilibrium employment,L

EQUILIBRIUM IN THE LABOR MARKET Labor supply and labor demand determine the equilibrium wage. Shifts in the supply or demand curve for labor cause the equilibrium wage to change.

Figure 5 A Shift in Labor Supply Copyright©2003 Southwestern/Thomson Learning Wage (price of labor) 0 Quantity of Labor Supply,S Demand reduces the wage and raises employment. 1. An increase in labor supply... S W L W L

Shifts in Labor Supply An increase in the supply of labor : Results in a surplus of labor. Puts downward pressure on wages. Makes it profitable for firms to hire more workers. Results in diminishing marginal product. Lowers the value of the marginal product. Gives a new equilibrium.

Figure 6 A Shift in Labor Demand Copyright©2003 Southwestern/Thomson Learning Wage (price of labor) 0 Quantity of Labor Supply Demand,D increases the wage and increases employment. D W L W L 1. An increase in labor demand...

Shifts in Labor Demand An increase in the demand for labor : Makes it profitable for firms to hire more workers. Puts upward pressure on wages. Raises the value of the marginal product. Gives a new equilibrium.

Table 2 Productivity and Wage Growth in the United States. Copyright©2004 South-Western

 Discrimination.  Minimum wage legislation.  Taxation and the incentive to work.  The importance of education and training. Further issues in the labour market

Figure 18.7 Illustrating the effects of discrimination on the labour market

Figure 18.8 Impact of minimum wage legislation

Figure 18.9 The impact of taxation

Figure Investment in human capital

OTHER FACTORS OF PRODUCTION: LAND AND CAPITAL  Capital  Land  More in next lecture …

19 Market for Capital

Input Demand: The Capital Market and the Investment Decision

The Capital Market

Capital One of the most important concepts in all of economics is the concept of capital. Capital goods are those goods produced by the economic system that are used as inputs to produce other goods and services in the future.

Physical Capital Physical, or tangible, capital refers to the material things used as inputs in the production of future goods and services. Major categories of physical capital: Nonresidential structures Durable equipment Residential structures Inventories

Social Capital Social capital is capital that provides services to the public. Major categories of social capital: Public works (roads and bridges) Public services (police and fire protection)

Intangible Capital Nonmaterial things that contribute to the output of future goods and services are known as intangible capital. For example, an advertising campaign to establish a brand name produces intangible capital called goodwill. Reputation

Human Capital Human capital is a form of intangible capital that includes the skills and other knowledge that workers have or acquire through education and training. Human capital yields valuable services to a firm over time.

Measuring Capital The measure of a firm’s capital stock is the current market value of its plant, equipment, inventories, and intangible assets. When we speak of capital, we refer not to money or financial assets such as bonds or stocks, but to the firm’s physical plant, equipment, inventory, and intangible assets.

Investment Investment refers to new capital additions to a firm’s capital stock. Although capital is measured at a given point in time (a stock), investment is measured over a period of time (a flow). The flow of investment increases the capital stock.

Private Investment in the U.S. Economy, 1999 BILLIONS OF CURRENT DOLLARS AS A PERCENTAGE OF TOTAL GROSS INVESTMENT AS A PERCENTAGE OF GDP Nonresidential structures Equipment and software Change in inventories Residential structures Total gross private investment1,  depreciation   58.3  10.3 Net investment = gross investment minus depreciation Depreciation is a decline in an asset’s economic value over time.Depreciation is a decline in an asset’s economic value over time.

The Capital Market The capital market is a market in which households supply their savings to firms that demand funds to buy capital goods.

$1,000 in Savings Becomes $1,000 of Investment

Bond Lending A bond is a contract between a borrower and a lender, in which the borrower agrees to pay the loan at some time in the future, along with interest payments along the way. In essence, households supply the capital demanded by a business firm. Presumably, the investment will generate added revenues that will facilitate the payment of interest to the household.

The Financial Capital Market The financial capital market is the part of the capital market in which savers and investors interact through intermediaries. Capital income is income earned on savings that have been put to use through financial capital markets.

Capital Income: Interest and Profit Interest is the payment made for the use of money. Interest is a reward for postponing consumption. Profit is the excess of revenues over cost in a given period. Profit is a reward for innovation and risk taking.

Financial Capital Markets in Action Four mechanisms for channeling household savings into investment projects include: Business loans Venture capital Retained earnings The stock market

Financial Markets Link Household Saving and Investment by Firms

Capital Accumulation and Allocation In modern industrial societies, investment decisions (capital production decisions) are made primarily by firms. Households decide how much to save, and in the long-run saving limits or constrains the amount of investment that firms can undertake. The capital market exists to direct savings into profitable investment projects.

Forming Expectations Decision makers must have expectations about what is going to happen in the future. The investment process requires that the potential investor evaluate the expected flow of future productive services that an investment project will yield.

The Demand for New Capital and the Investment Decision The ability to lend at the market rate of interest means that there is an opportunity cost associated with every investment project. The evaluation process thus involves not only estimating future benefits, but also comparing the possible alternative uses of the funds required to undertake the project. At a minimum, those funds earn interest in financial markets.

Comparing Costs and Expected Return The expected rate of return is the annual rate of return that a firm expects to obtain through a capital investment.

Determinants of the Expected Rate of Return The expected rate of return on an investment project depends on: the price of the investment, the expected length of time the project provides additional cost savings or revenue, and the expected amount of revenue attributable each year to the project.

A Menu of Investment Choices and Expected Rates of Return Potential Investment Projects and Expected Rates of Return for a Hypothetical Firm, Based on Forecasts of Future Profits Attributable to the Investment PROJECT (1) TOTAL INVESTMENT (DOLLARS) (2) EXPECTED RATE OF RETURN (PERCENT) A. New computer network400,00025 B. New branch plant2,600,00020 C. Sales office in another state1,500,00015 D. New automated billing system100,00012 E. Ten new delivery trucks400,00010 F. Advertising campaign1,000,0007 G. Employee cafeteria100,0005

A Menu of Investment Choices and Expected Rates of Return When the interest rate is low, firms are more likely to invest in new plant and equipment than when the interest rate is high. The interest rate determines the opportunity cost (alternative investment) of each project.

Investment Demand The market demand curve for new capital is the sum of all the individual demand curves for new capital in the economy. In a sense, the investment demand schedule is a ranking of all the investment opportunities in the economy in order of expected yield.

The Profit-Maximizing Investment Decision A perfectly competitive profit-maximizing firm will keep investing in new capital up to the point at which the expected rate of return is equal to the interest rate. This is analogous to saying that the firm will continue investing up to the point at which the marginal revenue product of capital is equal to the price of capital. MRP K = P K

Present Value The present value (PV), or present discounted value, of R dollars t years from now is: Lower interest rates result in higher present values. The firm has to pay more now to purchase the same number of future dollars.Lower interest rates result in higher present values. The firm has to pay more now to purchase the same number of future dollars.

20 Markets for Land

Market for Land Similar to the capital market in the sense we can use demand/supply tool to analyze it Difference is that land supply is often inelastic

Prices of Land The purchase price is what a person pays to own a factor of production indefinitely. The rental price is what a person pays to use a factor of production for a limited period of time.

Equilibrium in the Markets for Land and Capital The rental price of land ( and capital) are determined by supply and demand. The firm increases the quantity hired until the value of the factor ’ s marginal product equals the factor ’ s price.

Figure 7 The Markets for Land and Capital Copyright©2003 Southwestern/Thomson Learning Quantity of Land 0 Rental Price of Land Demand Supply Demand Supply Quantity of Capital 0 Rental Price of Capital Q P (a) The Market for Land(b) The Market for Capital P Q

Equilibrium in the Markets for Land and Capital Each factor ’ s rental price must equal the value of its marginal product. They each earn the value of their marginal contribution to the production process.

Linkages among the Factors of Production Factors of production are used together. The marginal product of any one factor depends on the quantities of all factors that are available.

Linkages among the Factors of Production A change in the supply of one factor alters the earnings of all the factors.

Linkages among the Factors of Production A change in earnings of any factor can be found by analyzing the impact of the event on the value of the marginal product of that factor.

A Case Study: Urban Land Market Supply of land is inelastic, demand is elastic P Q S D

Translating rents to land prices Rents are a function of: Agricultural land value Value of the structures Location value Expected growth in location value

Translating rents to land prices Prices are a function of: Interest rates Expected rent growth Risk of rental payment Tax regime

Land use efficiency indicated by high-degree of land-capital input substitution 土地和资本投入的 相互替代程度, 关系到城市土地使用效率的高低 Density Profile with Land Markets Paris

Summary The economy ’ s income is distributed in the markets for the factors of production. The three most important factors of production are labor, land, and capital. The demand for a factor, such as labor, is a derived demand that comes from firms that use the factors to produce goods and services.

Summary Competitive, profit-maximizing firms hire each factor up to the point at which the value of the marginal product of the factor equals its price. The supply of labor arises from individuals ’ tradeoff between work and leisure. An upward-sloping labor supply curve means that people respond to an increase in the wage by enjoying less leisure and working more hours.

Summary The price paid to each factor adjusts to balance the supply and demand for that factor. Because factor demand reflects the value of the marginal product of that factor, in equilibrium each factor is compensated according to its marginal contribution to the production of goods and services.

Summary Because factors of production are used together, the marginal product of any one factor depends on the quantities of all factors that are available. As a result, a change in the supply of one factor alters the equilibrium earnings of all the factors.